The Money Meets Medicine Podcast

Should I Invest Pre-Tax or Roth in my 401K?

By Jimmy Turner, MD
Host of Money Meets Medicine

Every paycheck comes with an invisible, yet crucial decision: where to invest for the future. The big decision? Pre-tax vs. Roth investing. For doctors, this isn’t just another choice—it’s a pivotal strategy that could shape their financial health far beyond retirement.

Roth investments stand out as a beacon of tax-free growth potential, but (like international stocks) they come with upfront costs – taxes paid today in hopes of saving more tomorrow. On the flip side, pre-tax options promise immediate relief from Uncle Sam but wait quietly to collect their dues in your golden years.

The stats are clear; choosing wisely could mean the difference between sailing smoothly into retirement or facing unexpected fiscal storms. Yet, amidst ever-shifting tax policies and economic climates, finding that sweet spot feels like searching for treasure without a map.

Let’s dissect the pre-tax versus Roth debate with some surgical precision—because when it comes to securing your financial future, there’s no room for error.

Table of Contents:

 

Understanding Pre-Tax vs. Roth Investing for Doctors

As a doctor, you’ve got a lot on your plate. Saving lives, keeping up with the latest medical research, and managing a practice are just a few of the things that keep you busy. But let’s not forget about your financial health too. When it comes to investing for retirement, you’ve got two main options: pre-tax and Roth. Understanding the difference between the two is crucial.

Pre-tax investing involves getting a tax break now and paying Uncle Sam later. You put money into your retirement account before taxes are taken out, which lowers your taxable income for the year. But when you retire and start withdrawing that money, you’ll have to pay taxes on it then.

Roth investing, on the other hand, involves paying taxes now and getting a tax break later. You put money into your Roth account after taxes have already been taken out. So you don’t get a tax break now, but when you retire and start withdrawing that money, you won’t have to pay taxes on it ever again.

Strategic Considerations for Doctors

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As a doctor, you’re in a higher tax bracket than the average Joe. In addition, the physician income journey is unique where we experience a lower income as residents/fellows and marked jump with that first attending physician paycheck.

The prevailing wisdom is that young individuals in lower tax brackets should opt for Roth investing (Roth = Resident), while attending physicians in higher tax brackets should consider pre-tax investing (Pre-Tax = Peak Earning Years). The idea is that you’ll be in a lower tax bracket when you retire, so you’ll pay less in taxes on your withdrawals then.

…but here’s the thing: it’s not always that simple. There are other factors to consider, like how much money you think you’ll need in retirement and what your tax situation might look like then.

The Role of Tax Rates and Historical Context in Investment Decisions

When it comes to deciding between pre-tax and Roth investing, it’s important to consider not just your current tax situation, but also potential future tax environments. And that’s where things can get a little tricky. Trying to predict future tax rates and policies is like trying to predict the weather a year from now. It’s not impossible, but it’s not exactly easy either.

Tax rates can change over time, and they have in the past. Just look at the historical context (image below from the source of all wisdom and trust, aka Wikipedia): in the 1950s, the top marginal tax rate was a whopping 90%. Today, it’s 37%. That’s a big difference. So when you’re deciding between pre-tax and Roth investing, it’s important to keep in mind that tax rates aren’t set in stone. They can and do change.

Historical Marginal Tax Rates

Learning from History

While we can’t predict the future with 100% accuracy. However, we can learn from the past. And the past tells us that tax rates have varied significantly over time. In the 1920s, the top marginal tax rate was just 25%. But by the 1940s, it had jumped to 94%. And in the 1980s, it was back down to 28%.

So what does this mean for you as a doctor deciding between pre-tax and Roth investing? It means that it’s important to consider a range of potential future tax scenarios. Don’t just assume that tax rates will stay the same as they are now. Ultimately, it might be best to hedge your bets and have money invested on both sides of the tax equation.

The Benefits of Tax Diversification

When it comes to investing for retirement, putting all your eggs in one basket is rarely a good idea. And that’s where tax diversification comes in. Tax diversification means having a mix of pre-tax and Roth investments. It’s like hedging your bets against future tax rate changes. Having both pre-tax and Roth accounts can give you more flexibility in retirement. You can strategically withdraw from each account based on your tax situation at the time.

For example, let’s say you retire in a year when tax rates are high. You could withdraw more from your Roth account, which won’t be taxed, and less from your pre-tax account, which will be taxed at a higher rate. On the flip side, if you retire in a year when tax rates are low, you could withdraw more from your pre-tax account and pay less in taxes.

Employer-Sponsored Plans as a Diversification Tool

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As a doctor, you may have access to employer-sponsored retirement plans like a 401(k) or 403(b). And these plans can be a great tool for achieving tax diversification. Since Secure 2.0 came into effect, employers can now match on either a pre-tax or post-tax (Roth) basis.

That said, for the employers that provide matching and contributions, it is typically performed on a pre-tax basis. This is important to consider as one tactic that you might take to provide tax diversification is to place your 401K or 403B retirement savings into your accounts in a Roth fashion. This way, when your employer provides their (pre-tax) matching it automatically creates tax diversification.

Strategic Roth Conversions and Estate Planning

What if you want to be a pre-tax super saver? Are there any options to take advantage later?

As you get closer to retirement, you may want to start thinking about strategic Roth conversions and estate planning. And that’s where things can get really interesting.

A Roth conversion is when you take money from a pre-tax account, like a traditional IRA, and move it into a Roth account. You’ll have to pay taxes on the amount you convert, but then that money can grow tax-free in the Roth account. Doing Roth conversions in your 60s, when you may be in a lower tax bracket than you were during your peak earning years, can be a smart way to optimize your tax planning. You’ll pay taxes on the conversion at a lower rate, and then that money can grow tax-free for the rest of your life.

Minimizing Taxes for Heirs with Roth Accounts

Roth accounts can also be a valuable tool for estate planning. Unlike pre-tax accounts, Roth accounts don’t have required minimum distributions (RMDs) during your lifetime. That means you can let that money keep growing tax-free for as long as you want.

When you pass that Roth money on to your heirs, they won’t have to pay taxes on the withdrawals either. That can be a huge benefit, especially if your heirs are in a high tax bracket. Plus, giving money to your children or heirs earlier in life, when they may need it most, can be a valuable financial strategy. With a Roth account, you can do that without saddling them with a big tax bill.

Key Takeaway: 

Understanding the difference between pre-tax and Roth investing is key for doctors to optimize retirement savings. While pre-tax lets you save on taxes now, Roth accounts offer tax-free withdrawals later. Considering future tax scenarios, diversifying with both types of investments can provide flexibility and potential tax advantages in retirement.

Conclusion

So, here we are at the crossroads of pre-tax vs. Roth investing. The verdict? There’s no one-size-fits-all answer. Ultimately, the best bet is to do what every good radiologist does and hedge your bets with both pre-tax and Roth investments. This way, you need not fear changes in politics and policy that may impact the tax code in your retirement years.

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The real magic happens when you blend historical insights with future predictions, ensuring your portfolio isn’t just surviving but thriving through the ebbs and flows of tax policies.

Who knew digging into pre-tax vs. Roth investing could reveal so much more than numbers—it unveils pathways to freedom, legacy building, and peace of mind?

P.S. Looking for a free book to help you understand the 20% of personal finance doctors need to know to get 80% of the results? This is the book I’d recommend.

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